Europe’s Newest Agreement No Panacea

Debt crisis could spur challenge to U.S. treasuries

European leaders met last week in emergency session to hammer out a deal to stave off a disorderly default by Greece and to stabilize conditions in the continent’s sovereign debt markets. In extending more than $150 billion in contingent aid to Greece (including some hits taken by private creditors) and affording more flexibility in the use of the European Financial Stability Authority, the deal is an aggressive attempt to preempt further contagion.

That is an important consideration. From my discussions this week with colleagues in Germany and Switzerland, European central bankers and the core nations’ heads of state are acutely aware that they lack the tools to manage a wider crisis.

Regrettably, markets have largely internalized Greece’s orderly default and are now focused on conditions in other countries—including Portugal and Ireland—that have seen little new consideration as a result of the Greek agreement, but that present more difficult tests of European consensus.

In fact, the threat no longer relates to specific countries in the minds of many economists, policy makers and bond investors, but to the durability of the European economic and monetary union itself. Leaders are understandably wary of visiting issues of how the market is structured; doing so now might unseal Pandora’s box.

A Eurobond?

There is no sovereign entity in Europe that is sufficiently removed from the vagaries of its politics that it could serve as a backstop for further crisis. Germany would have to be part of any such program. But Chancellor Angela Merkel is already under threat at home from her perceived largesse in Brussels.

And so Europe still finds itself unequipped to deal with the crisis except on a country-by-country basis and at a pace that belies the rapidity with which investors might sour on a particular sovereign issuer.

Eurobonds, coupled with the European Central Bank balance sheet, could address the absence of a tool that is sufficiently scalable and flexible to bolster market confidence. Politically, such a program would be a tough sell. The implicit or explicit guarantee of Eurobonds by member countries would likely impact the credit ratings of the major economies, principally Germany and France, raising their borrowing costs.

Little short of the threat of the euro zone’s dissolution would empower Chancellor Merkel to forward a proposal of this nature at home.

Regarding the U.S.

The possibility of a Eurobond also has implications for the United States. The puerile debt debate at home leaves the ratings agencies with little choice but to downgrade Treasuries in the coming months, even if an agreement is reached by the early-August debt-ceiling deadline.

The notion that U.S. government bonds are free of any risk is no longer credible from a risk-management perspective. An adjustment must ensue to reflect that default is a tail risk with non-zero probability. All else being equal, losing its gold-standard credit rating will mean marginally higher Treasury yields that are structural rather than cyclically driven. Couple this with a complement to or substitute for the Treasury in Europe, and yields must rise again in the United States as the global supply curve of relatively low-risk sovereign bonds shifts out.

In all, the long-term result of the sophomoric approach to debt and deficit politics in the U.S. and the potential for a new class of sovereign bonds to emerge in Europe means that higher underlying costs of financing—in terms of treasuries and any instrument measured over them—will ultimately prove to be among the legacies of this crisis.

dsc@chandan.com

Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School.